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By Christine Benz and David Blanchett | 01-30-2013 10:00 AM

Time for the 3% Withdrawal Rule?

Low bond yields have called into question the safety of the 4% withdrawal strategy, while other avenues for extra retirement income have their own pros and cons, says Morningstar's David Blanchett.

Note: This video is being re-featured as part of Morningstar's October 2014 5 Keys to Retirement Investing special report. This video originally appeared in January 2013.

How to set a sustainable withdrawal rate is a crucial topic for retirees. With bond yields as low as they are, a recent study by David Blanchett, Michael Finke, and Wade Pfau suggests that a 3% withdrawal rate--rather than the so-called 4% rule--will help improve retirees' probability of success. Click here to read the paper in its entirety.

Christine Benz: Hi, I'm Christine Benz for What do low bond yields mean for retirement planning? Here to discuss that topic is David Blanchett; he is head of retirement research for Morningstar.

David, thank you for being here.

David Blanchett: Thanks for having me.

Benz: So, one of the key strategies that retirees use is what's called the 4% rule. It looks back on a lot of historical data, and the basic idea is that you can withdraw 4% of your portfolio on day one of retirement, and then inflation-adjust that amount down the line. It starts with a 60-40 portfolio, correct, and the assumption is that it lasts 30 years?

Blanchett: Yes.

Benz: You've done some recent research though that looks at where bond yields are now and suggest that maybe a different formula is smarter given the meager returns that one might expect from bonds. Let's talk about your research. It's a draft paper that you're working on, but it's important so we wanted to get it out there. Let's talk about what your findings are?

Blanchett: Well, if we think about research on retirement income, most papers have used kind of long-term averages--so stocks go up 10% a year, and bonds returned 5% a year. It assumes that that those returns are available every year in retirement. So, in year one, you can earn 5% on bonds and 10% on stocks and in every year for 30 years.

As we know today, though, you can't earn 5% on bonds. And so when you change kind of the model from assuming these long-term averages to where things are today, if they kind of drift back toward their long-term average, you see a very different outcome in terms of what is safe for retirement.

Benz: It sounds like a lower withdrawal rate than 4%. What do the data suggest given where bond yields are currently?

Blanchett: So, a metric that we use in retirement-income research is the probability of failure, and that's how many times over a simulation your outcome fails. How many times can you achieve your goal of taking out 4% in year one, adjusted for inflation for 30 years? The 4% rule, as it is called, had about a 10% chance of failure, which is pretty good. But using yields today, it's more like 50%. And so the safety of that 4% strategy is very much open to question. So, what we found kind of in our research was that 3% is a better kind of starting place for retirees right now.

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